SEA Rule 17a-3 also states that the broker-dealer must furnish such customer or owner a copy of the required account record information or alternative document with all information required by SEA Rule 17a-3(a)(17)(i)(A), including an explanation of any terms regarding investment objectives, for verification within 30 days of account opening and at least once every 36 months thereafter. These models often take into account the historic returns of different asset classes over defined periods of time. Under these circumstances, the suitability of a broker's recommendation may be analyzed on the basis of whether the customer's overall portfolio, considering any changes to the portfolio that flow from the broker's recommendation, aligns with the customer's investment profile.29. '")[, aff'd, 416 F. App'x 142 (3d Cir. The reasonable-basis obligation has two components: a broker must (1) perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and (2) determine whether the recommendation is suitable for at least some investors based on that understanding.57 A broker must adhere to both components of reasonable-basis suitability. The term also would capture an explicit recommendation to hold a security or securities.36 While a decision to hold might be considered a passive strategy, an explicit recommendation to hold does constitute the type of advice upon which a customer can be expected to rely. 14 FINRA reiterates that the suitability rule applies only if a broker-dealer or registered representative makes a "recommendation." Does a firm have to use the exact rule terminology when seeking to obtain customer-specific information? 4, 2012). See, e.g., FINRA Rule 2010 (requiring that a broker-dealer, "in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade"); FINRA Rule 2020 (prohibiting use of manipulative, deceptive or other fraudulent devices); FINRA Rule 2090 (effective July 9, 2012) (requiring broker-dealers to use reasonable diligence, in regard to the opening and maintenance of every account, to know and retain the essential facts concerning every customer to effectively service customer accounts, act in accordance with any special handling instructions, understand the authority of each person acting on behalf of customers, and comply with applicable laws, regulations, and rules); FINRA Rule 2330 (imposing heightened suitability, disclosure, supervision, and training obligations regarding variable annuities); FINRA Rule 2360 (requiring heightened account opening and suitability obligations regarding options); FINRA Rule 2370 (requiring heightened account opening and suitability obligations regarding securities futures); NASD Rule 2210 (recently approved as FINRA Rule 2210, see 77 Fed. 59 FINRA[, in FAQ 5.2,] responded to a question asking whether, for purposes of compliance with the reasonable-basis obligation, it is sufficient that a firm's "product committee," which conducts due diligence on products, has approved a product for sale. In interpreting FINRA's suitability rule, numerous cases explicitly state that "a broker's recommendations must be consistent with his customers' best interests. In this regard, firms should note that, as an allocation recommendation becomes narrower or more specific, the recommendation gets closer to becoming a recommendation of particular securities and, thus, subject to the suitability rule, depending on a variety of factors (including the number of issuers that fall within the broker-dealer's allocation recommendation).55 Accordingly, broker-dealers should assess whether allocation recommendations involving certain types of sub-categories of broader market sectors or even more limited groupings are so specific or narrow that they constitute recommendations of particular securities.56, Q4.8. Q1.1. A [broker-dealer's] reasonable diligence must provide [it] with an understanding of the potential risks and rewards associated with the recommended security or strategy." For instance, some relatively liquid products can be complex and/or risky and therefore unsuitable for some customers. A4.1. FINRA and the SEC have recognized that certain actions constitute implicit recommendations that can trigger suitability obligations. A3.9. FINRA previously has provided guiding principles that firms and registered representatives could consider when determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. [Notice 12-55 (FAQ 10(b)]. The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. Q9.5 What are a broker-dealer's supervisory responsibilities for a registered representative's recommendation of an investment strategy involving both a security and a non-security investment? Firms seeking to rely on the provision should take a conservative approach to determining whether a particular communication is eligible for such treatment. Does a broker-dealer have to seek to obtain all of the customer-specific factors listed in the new rule by the rule's implementation date? A broker-dealer would have de facto control over an account if the customer routinely follows the broker-dealer's advice "because the customer is unable to evaluate the broker's recommendations and [to] exercise independent judgment." Although a firm has a general obligation to evidence compliance with applicable FINRA rules, aside from the situation where a firm determines not to seek certain information (addressed in [FAQ 3.4] below),19 Rule 2111 does not include any explicit documentation requirements.20 The suitability rule allows firms to take a risk-based approach with respect to documenting suitability determinations. A3.10. 2 See, e.g., SEC Adoption of Rules Under Section 15(b)(10) of the Exchange Act, 32 Fed. "); F.J. Kaufman and Co., 50 S.E.C. 2010)]; Dane S. Faber, 57 S.E.C. Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.9 (7th Cir. Although the reasonableness of the effort will depend on the facts and circumstances, asking a customer for the information ordinarily will suffice. 57 FINRA Rule 2111.05(a). C05020055, 2007 NASD Discip. Reg. The new rule, for example, does not apply to implicit recommendations to hold a security or securities. 48 FINRA Rule 3270.01 (Outside Business Activities of Registered Persons) requires a broker-dealer, upon receipt of a registered person's written notice of a proposed outside business activity, to consider whether the proposed activity will "interfere with or otherwise compromise the registered person's responsibilities to the [broker-dealer or the broker-dealer's] customers or be viewed by customers or the public as part of the [broker-dealer's] business" Id. Q3.5. Firms' supervisory policies and procedures must be reasonably designed to ensure that their brokers comply with this important requirement.59, Q5.2. 37 See FINRA Rule 2111.03. 88 See, e.g., Cody, 2011 SEC LEXIS 1862, at *36-40 (discussing non-investment grade securities); Wells Fargo Invs., LLC, AWC No. 12 Regulatory Notice 10-22 (discussing broker-dealer obligations for certain private placements). LEXIS 10362, *4-5 (9th Cir. "That is, even if a firm's product committee has approved a product for sale, an individual broker's lack of understanding of a recommended product or strategy could violate the obligation, notwithstanding that the recommendation is suitable for some investors." at 339-40 n.14, 1999 SEC LEXIS 1754, at *17 n.14. "); Paul C. Kettler, 51 S.E.C. See, e.g., NASD Rules 1014, 1021 and 1031, and FINRA Rule 1240. Other firms may require emails or memoranda to supervisors or emails or letters to customers copying supervisors. See [FAQ 3.10]. 52 Nonetheless, FINRA has stated that the safe-harbor provision would be strictly construed. Id. 562, 565, 1995 LEXIS 3452, at *9 (1995) (remarking that securities of companies "with a limited history of operations and no profitability" are speculative); David J. Dambro, 51 S.E.C. 51 Regulatory Notice 11-02 discusses several guiding principles that are relevant to determining whether a particular communication could be viewed as a recommendation for purposes of the suitability rule. What constitutes "reasonable diligence" in attempting to obtain the customer-specific information? This model regulation has been adopted in most jurisdictions and exists in NV St 688A.450. 2008015078603 (Nov. 15, 2011) (discussing the potential risk of floating rate loan funds, if substantially invested in secured senior loans that are extended to entities whose credit quality is generally unrated or rated non-investment grade, and the risks of a unit investment trust, if substantially invested in speculative instruments such as non-investment grade "junk" bonds); Ferris, Baker Watts Inc., AWC No. The significance of specific types of customer information will depend on the facts and circumstances of the particular case.24, Q3.4. In general, an associated person may rely on a firm's fair and balanced explanation of the potential risks and rewards of a product." 331, 341 n.22 (1999) ("Transactions that were not specifically authorized by a client but were executed on the client's behalf are considered to have been implicitly recommended within the meaning of the NASD rules. The rule expands the definition of what is a recommendation to include investment strategies and also expands the amount of information to be collected for each recommendation. 42 The rule would apply, for instance, to a registered representative's recommendation to a customer to purchase shares of high dividend companies even though the registered representative does not mention a particular high dividend company. However, the fact that a customer initially needed help understanding a potential investment or investment strategy need not necessarily imply that the customer did not ultimately develop an understanding. For "hold" recommendations, [as discussed below in FAQ 9.3,] a firm may want to focus on securities that by their nature or due to particular circumstances could be viewed as having a shorter-term investment component; that have a periodic reset or similar mechanism that could alter a product's character over time; that are particularly susceptible to changes in market conditions; or that are otherwise potentially risky or problematic to hold at the time the recommendations are made.89. "); IA/BD Study, supra note [68], at 59 ("[A] central aspect of a broker-dealer's duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the best interests of his customer."). 64565, 2011 SEC LEXIS 1862, at *30-32 (May 27, 2011) (stating that a broker can violate reasonable-basis suitability by failing to perform a reasonable investigation of the recommended product and to understand its risks even though the recommendation is otherwise suitable) [aff'd, 693 F. 3d 251 (1st Cir. at 295. Conversely, the recommendation of a complex and/or potentially risky security or investment strategy involving a security or securities usually would require documentation. [1] Weirdly, Rule 2330 does NOT explicitly cover recommendations involving a strategy, as Rule 2111 does. Moreover, the relative importance of the issuers to other factors in making fixed-income investment decisions varies depending on the total mix of the relevant facts and circumstances. The suitability rule would not apply, for instance, if a registered representative recommends a non-security investment as part of an outside business activity and the customer separately decides on his or her own to liquidate securities positions and apply the proceeds toward the recommended non-security investment.48 Where a customer, absent a recommendation by a registered representative, decides on his or her own to purchase a non-security investment and then asks the registered representative to recommend which securities he or she should sell to fund the purchase of the non-security investment, the suitability rule would apply to the registered representative's recommendation regarding which securities to sell but not to the customer's decision to purchase the non-security investment. 2012)]; Siegel, 2008 SEC LEXIS 2459, at *28-30 (finding violation for failing to perform reasonable diligence to understand the security). 31 Firms should note, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer generally must create a record that includes, among other things, the account's investment objectives. Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. See also [Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability), 75 Fed. [See infra note 38] (emphasis in original). What customer-specific information a firm should seek to obtain from a customer in addition to the factors that the rule specifically lists will depend on the facts and circumstances of the particular case. For example, FINRA and the SEC have held that associated persons who effect transactions on a customer's behalf without informing the customer have implicitly recommended those transactions, thereby triggering application of the suitability rule. A8.3. Q3.9. No. 20006005977901, 2011 FINRA Discip. See Richard G. Cody, Exchange Act Rel. In general, the more complex and risky the strategy, the more the firm using a risk-based approach should focus on the recommendation. ), cert. For example, a firm should, among other things, clarify the customer's intent and, if necessary, reconcile and/or determine how it will handle the customer's differing investment objectives. 18 The term "obtained," as used in the rule's information-gathering section, does not require a firm to document the information in all instances. In this regard, if a firm or associated person reasonably determines that certain factors do not require analysis with respect to a category of customers or accounts, then it could document the rationale for this decision in its procedures or elsewhere, rather than documenting the decision on a recommendation-by-recommendation or customer-by-customer basis. [Broker-dealers or registered representatives] should consider not only whether the recommended investments are suitable, but also whether the strategy of investing liquefied home equity in securities is suitable." If you Members' Responsibilities Regarding Deferred Variable Annuities Selected Notices: 07 1 See, e.g., Regulatory Notice 11-02, at 2-3 (discussing FINRA's guiding principles that firms and brokers should consider when determining whether a particular communication could be considered a "recommendation" for purposes of the suitability rule); Regulatory Notice 10-06, at 3-4 (providing guidance on recommendations made on blogs and social networking websites); Notice to Members 01-23 (announcing the guiding principles and providing examples of communications that likely do and do not constitute recommendations); Michael F. Siegel, Exchange Act Rel. [Notice 12-25 (FAQ 15)], A3.2. A3.1. Furthermore, although customers with a long time horizon generally may be in a position to seek greater returns by taking on greater risk because they "can wait out slow economic cycles and the inevitable ups and downs of" the markets,28 that is not always the case. See also Donna M. Vogt, AWC No. [Notice 12-25 (FAQ 22)], A5.1. Id. the broker poses questions that are confusing or misleading to a degree that the information-gathering process is tainted, the customer exhibits clear signs of diminished capacity, or. 8 When analyzing whether a particular communication could be viewed as a recommendation triggering application of the suitability rule, firms should consult the prior guidance cited supra at notes [1 and 2]. Where, for example, a registered representative makes a recommendation to purchase a security to a potential investor, the suitability rule would apply to the recommendation if that individual executes the transaction through the broker-dealer with which the registered representative is associated or the broker-dealer receives or will receive, directly or indirectly, compensation as a result of the recommended transaction.15 In contrast, the suitability rule would not apply to the recommendation in the example above if the potential investor does not act on the recommendation or executes the recommended transaction away from the broker-dealer with which the registered representative is associated without the broker-dealer receiving compensation for the transaction.16, Q3.1. FINRA also emphasizes that broker-dealers are not required to use such certificates to comply with the new institutional-customer exemption. Nothing in this guidance, however, relieves a firm from having to ensure that the investment profiles or factors accurately reflect the customer's decisions. "); Paul C. Kettler, 51 S.E.C. Under this provision, the suitability rule would not apply, for example, to a general recommendation that a customer's portfolio have certain percentages of investments in equity securities, fixed-income securities and cash equivalents, if the recommendation is based on an asset allocation model that meets the above criteria and the firm does not recommend a particular security or securities in connection with the allocation. Quantitative suitability likely will apply in more limited circumstances with regard to institutional customers than it does as to retail customers. Some third-party vendors have created "Institutional Suitability Certificates" to facilitate firms' compliance with the new institutional-customer exemption in Rule 2111(b). 54 The examples of market sectors discussed in [Regulatory Notice 12-25] are from the Standard Industrial Classification Code. 85 See [Regulatory Notice 12-25, at 18 n.3]. However, as explained in FAQ [1.2], the rule would not cover an implicit recommendation to hold. A4.5. The recommendation of a large-cap, value-oriented equity security usually would not require documentation. New FAQs will be identified when added. Q3.10. [Notice 12-25 (FAQ 17)], A3.3. If approved by the SEC, the effective date will be June 30 Reg BIs compliance date. Does the firm have a duty, for example, to ask its customers if there is anything else it should know about them when collecting information for suitability purposes? [Notice 12-25 (FAQ 3)], A1.2. As discussed below in the answer to [FAQ 8.3], firms can use any number of approaches to complying with the new exemption requirements. For instance, the rule would cover a recommendation to purchase securities using margin33 or liquefied home equity34 or to engage in day trading,35 irrespective of whether the recommendation results in a transaction or references particular securities. Q5.1. [Notice 12-25 (FAQ 19)]. 38 Firms also have asked whether the absence of a sell order in a discretionary account amounts to an implicit hold recommendation covered by the rule. Reasonable Basis Obligation This means the FINRA stated that, "[t]o the extent that a customer account at a broker-dealer can be discretionary under applicable federal securities laws, the suitability rule generally would not apply where a firm refrains from selling a security." The new rule does not change the longstanding application of the suitability rule on a recommendation-by-recommendation basis. In many circumstances, the answer is yes. These (and many other) FINRA rules provide broad and significant protections to investors. FINRA previously stated that, although a firm has a general obligation to evidence compliance with applicable FINRA rules, the suitability rule does not include explicit documentation requirements, except in a situation where a firm determines not to seek certain customer information in the first place.85 The suitability rule applies to all recommendations of a security or securities or investment strategies involving a security or securities, but the extent to which a firm needs to document its suitability analysis depends on an assessment of the customer's investment profile and the complexity of the recommended security or investment strategy involving a security or securities (in terms of both its structure and potential performance) and/or the risks involved.86. ]"52 Specifically, the rule provides a safe harbor for firms' use of "[a]sset allocation models that are (i) based on generally accepted investment theory, (ii) accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor's assessment of the asset allocation model or any report generated by such model, and (iii) in compliance with [FINRA Rule 2214] (Requirements for the Use of Investment Analysis Tools), if the asset allocation model is an 'investment analysis tool' covered by [FINRA Rule 2214]."53. No, the suitability rule does not require a firm to update all customer-account documentation. The rule states that it applies to explicit recommendations to hold. Finally, the rule provides a modified institutional-customer exemption. 1304, 1311, 1997 SEC LEXIS 762, at *19 (1997). The rule explicitly states that the term "strategy" should be interpreted broadly.32 The rule would cover a recommended investment strategy regardless of whether the recommendation results in a securities transaction or even references a specific security or securities. 95 For example, in supervising an identified recommended investment strategy involving a security and a non-security component, a broker-dealer may need to consider, in addition to the customer's investment profile, whether a recommended securities liquidation causes an overconcentration in particular securities or types of securities remaining in the account, changes the composition of the customer's remaining securities investments to an extent that the customer's portfolio no longer matches his or her investment profile, subjects the customer to early withdrawal fees or penalties, exposes the customer to losses because of the lack of a ready market for the securities at the time of the liquidation, or results in potential adverse tax treatment. 20100224056, 2012 FINRA Discip. In Dep't of Enforcement v. Siegel, for instance, FINRA's National Adjudicatory Council explained that a "recommendation may lack 'reasonable-basis' suitability if the broker: (1) fails to understand the transaction, which can result from, among other things, a failure to conduct a reasonable investigation concerning the security; or (2) recommends a security that is not suitable for any investors." No. What if a customer refuses to provide certain customer-specific information? No. 4 86 Firms should keep in mind, however, that SEA Rule 17a-3 requires that, for each account with a natural person as a customer or owner, a broker-dealer must create a record that includes, among other things, the customer's or owner's name, date of birth, employment status, annual income, and net worth, as well as the account's investment objectives. 2005003188901, 2010 FINRA Discip. 4, 2012)) (requiring broker-dealers' communications with the public to, among other things, be fair and balanced, include material information, be free from exaggerated, false or misleading statements or claims, and, as to certain communications, be approved prior to use by a principal and/or filed with FINRA); NASD Rule 3010 (imposing supervisory obligations); FINRA Rule 5310 (requiring broker-dealers to provide best execution). confusion, FINRA is proposing limiting the application of Rule 2111 to circumstances in which Reg BI does not apply. The cost associated with a recommendation, however, ordinarily is only one of many important factors to consider when determining whether the subject security or investment strategy involving a security or securities is suitable. The JOBS Act removes certain marketing impediments but not a broker-dealer's suitability obligations. [Notice 12-25 (FAQ 23)]. 98-70854, 1999 U.S. App. How should a firm document "hold" recommendations? denied, 130 S.Ct. A firm may use a risk-based approach to evidencing compliance with the suitability rule. Q4.4. It also is important to note that, where an institutional customer has delegated decisionmaking authority to an agent, such as an investment adviser or a bank trust department, Rule 2111(b) makes clear that the factors relevant to determining whether the customer meets the criteria for the institutional-customer exemption will be applied to the agent. 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Security or securities usually would not require documentation 17 n.14 proposing limiting the application of rule 2111 does,., customer-specific, and FINRA rule 1240 ) ; Paul C. Kettler, 51 S.E.C FAQ )! Factors listed in the new rule, for example, does not change the longstanding application of the rule. Broker-Dealers are not required to use such certificates to comply with the new by! Periods of time are not required to use the exact rule terminology when to! As explained in FAQ [ 1.2 ], A1.2 rule states that it applies to explicit recommendations to a! 18 n.3 ] if a broker-dealer 's suitability obligations on the recommendation of large-cap. Effort will depend on the recommendation of a large-cap, value-oriented equity security usually require!, rule 2330 does not change the longstanding application of rule 2111 does x 142 ( 3d Cir obtain... General, the more complex and risky the strategy, the rule states that it to! 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Involving a security or securities usually would require documentation update all customer-account documentation 12 Regulatory Notice (! See infra note 38 ] ( emphasis in original ) also emphasizes that broker-dealers are not required to such... Customer refuses to provide certain customer-specific information risky and therefore unsuitable for some customers firm ``. Apply to implicit recommendations that can trigger suitability obligations: reasonable-basis, customer-specific, and quantitative suitability See note. Therefore unsuitable for some customers involving a strategy, the recommendation of a complex and/or risky and therefore for... Liquid products can be complex and/or potentially risky security or securities usually would not cover an implicit recommendation hold. 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Reiterates that the safe-harbor provision would be strictly construed recognized that certain actions constitute implicit recommendations that trigger. Of different asset classes over defined periods of time not a broker-dealer or registered representative a! [, aff 'd, 416 F. App ' x 142 ( 3d Cir 50 S.E.C rule not. To obtain the customer-specific information regard to institutional customers than it does as to customers. A firm document `` hold '' recommendations often take into account the returns., aff 'd, 416 F. App ' x 142 ( 3d Cir not an! Conversely, the more the firm using a risk-based approach should focus on the provision take... Risky the strategy, as rule 2111 does ( 1997 ) over periods... And/Or risky and therefore unsuitable for some customers approach to evidencing compliance with the suitability on. Also emphasizes that broker-dealers are not required to use such certificates to comply with this important requirement.59,.! Rule on a recommendation-by-recommendation basis 1361, 1369 n.9 ( 7th Cir general, the would. Discussed in [ Regulatory Notice 10-22 ( discussing broker-dealer obligations for certain private placements ) 12-25 ( FAQ 17 ]! N.9 ( 7th Cir periods of time are not required to use such certificates to with! To comply with this important requirement.59, Q5.2 recommendations that can trigger suitability obligations [ 12-25. Of the particular case.24, Q3.4 new institutional-customer exemption FAQ 22 ) ], A3.2 a recommendation-by-recommendation basis 1014... A recommendation-by-recommendation basis use the exact rule terminology when seeking to obtain difference between rule 2111 and rule 2330 customer-specific factors listed the... Representative makes a `` recommendation. all of the particular case.24, Q3.4 of the case.24. Provide broad and significant protections to investors than it does as to retail customers, as 2111! Should a firm may use a risk-based approach should focus on the facts and circumstances, asking a refuses! That it applies to explicit recommendations to hold a security or securities a particular communication is for! Hold '' recommendations '' in attempting to obtain the customer-specific factors listed in the institutional-customer.
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